Is UK equity income back in fashion?

Darius McDermott 04/08/2022 in Income investing

In this interview, Darius McDermott speaks with Andy Marsh, co-manager of Artemis Income fund, regarding the good start to 2022 for UK dividends. Andy also gives his views on what the second half of the year could hold in store for UK equity income, outlining two positives for the sector: strong dividend streams and record levels of share buybacks. Darius and Andy also discuss opportunities in mid-caps and end with financials, focusing on life insurance and the fund’s largest holding 3i Group.

Please Note: Below is a transcript of the video, modified for your reading pleasure. Please check the corresponding video before quoting in print, as it may contain small errors.

Maybe UK equities are back in favour, who knows? They are the least bad performing asset class this year! So, thank you for coming on and taking the time to talk to us about your fund. So, UK companies and UK dividends have had a good start to 2022, especially compared to other markets, as I say. How do you feel about valuations and the outlook for UK equities throughout the rest of the year?

[00:41] I think pretty positive overall, Darius. As you say, we’ve certainly been a better performing market this year. You will have seen us write a couple of times over the last few years – at times, the UK market’s been about as popular as a North Korean travel brochure! And it’s nice to find that we’ve seen a bit of a change and I think that’s really driven by a couple of things. I think firstly its defensive characteristics have come to the fore a little bit. I think the starting point for valuation was good, for all sorts of reasons. And then maybe we’ll talk about it a bit later, but that dividend income stream that the UK delivers, which actually has improved in quality post COVID, also has real value in markets that are challenging elsewhere.

So, I think there are a number of things that are stacking up that are positive, and we’ve actually seen a new buyer of the market in the last 6-12 months as well. And that’s the companies themselves – share buybacks are at record levels. And I think that’s a really positive indication, not only of what the companies are seeing in terms of their prospects, but also the strength of the balance sheets and that margin of safety that we have here in the UK today.

So, you touched briefly there on share buybacks and dividends. Do you think – and I know some companies had a dividend reset, if you like – do you think overall that was healthy for those companies and UK PLC, which is still one of, if not the premium yielding market in the world?

[02:13] We do think it was healthy actually. I think there was clearly a couple of sectors, and it was really oils and banks that were over-distributing in the UK. And we’d felt that for some time, we’d been underweight those sectors coming into the crisis, and they were delivering in 2019 about 35% of the UK dividend income stream. That’s down to about 20% today. So, you’ve got much more diversity across the UK market today.

And, clearly, in the oil sector, today’s cash flows are incredibly strong and that dividend is growing, but it’s from a starting point of a UK market yield rather than being disproportionately high. So, I think that’s important, but I’d say that it also meant that the cash cover of that dividend yield’s improved as well. So, the market yield – and indeed our fund yield – today is just over 4% and that’s covered by a free cash flow of about 7.5%. Which we think again is an important margin of safety when we’re looking at that dividend stream in the UK today.

And just on share buybacks, because I keep things simple… I’m a company, I’ve got cash. I can give it to you as a dividend or I can buy my shares back. Do you like share buybacks as an income manager? Or can we have both?

[03:29] So, I think there’s a couple of things to say. When we sit with our companies and we talk about what they’re doing with their cash flow, actually 80-90% of our conversation, if not more, is about actually what they can invest in and where they can invest for growth. And that’s really our priority because investing for future cash flows is the dividends of tomorrow. So that’s where we focus our time. And then, beyond that, you’ve clearly got cash flow left over – certainly in our companies. And then there’s an option, there’s that dividend, and then there’s a share buyback, and we want a regular dividend stream, and we want that to be something that’s committed to in a prudent way.

But the nice thing about share buybacks is they are discretionary, and they are one off. And where we see share buybacks done with an eye to the return on capital that buying and owning company shares actually delivers, that’s where we like them.

So, where we see a company looking at its own shares and thinking about, for example, a hurdle rate of 8%, that’s incredibly enhancing to us when those shares are bought back, they’re canceled. So, we have a lower share count going forward. The free cash flow hopefully can still grow. So, as long-term shareholders, we are left with a higher free cash rate per share than we had in the beginning.

So, for us, it shouldn’t be done blindly, shouldn’t be done irrespective of valuation, and certainly shouldn’t be done – as we’ve seen in some markets – to actually fulfill the issuance of shares for employee option schemes. For example, in the US market, well documented a trillion dollars of share buyback a year, mostly it covers share issuance. And what we see in the UK today is a high proportion of companies buying back shares, but canceling those shares, which we think is really very important. So, we are seeing share counts come down.

And whilst I know your fund is majority large cap, you do have around 20% in the mid-size companies or the mid-cap. How are you finding that opportunity set today, again in a world where lots of markets have been sold off – mid-caps are not immune. Does that give you a greater opportunity set?

[05:37] It’s interesting when we look at both sector labels and size labels for companies, they can be a bit misleading. Large cap is deemed as the FTSE 100. Actually, the FTSE 100 is quite concentrated, 65% of it is in the top 20 companies. We’re actually underweight those companies. We only have 25% of the fund there.

So, where we are large-cap we’re in those smaller FTSE 100 companies. To have a medium market capitalisation of probably 7 or 8 billion sterling, which in the context of the world is actually quite small companies. I always find it quite amusing when I talk to our US small cap guys and their limit on market cap is 10 billion dollars, as small cap investors. So, I think when we put those companies, many of which are international businesses, they actually are relatively modestly sized, even though they are in the FTSE 100.

But to step back and answer your question more directly, no, I think we are seeing some opportunities in the mid-cap space, reflecting the pullback that we’ve seen given the domestic exposure of that index area in aggregate. And I think you might see that mid-cap exposure creep up over the next few months. There are a couple of names that we’ve been adding recently.

Excellent. So then, finally, Andy, if we could, let’s just talk about financials. I know we often think of financials as just banks. I’m sure you’ve got a broad range, but you got a third of the fund in financials as categorised as a sector. Maybe tell us a little bit about why you’re finding them attractive and, if you’d be good enough, to pick out maybe one example for us.

[07:13] It comes back to those labels that can be a little misleading. With financials, often people think about banks, we’ve actually got 5% of the fund in banks versus the market, which is around 10%. So, we’re actually underweight banks. We’re overweight insurance and particularly life insurance, where we like the asset quality in those businesses today alongside very low leverage or very high solvency ratios. So, what we deem as very low risk, very long duration businesses that are giving us very good yields today, on average probably around 7%.

And then outside of that sort of 15% that we have in banks and insurance, we have an eclectic idiosyncratic mix of businesses in the financial space and it’s things like LSE group, IG index and 3i, which is the largest holding in the fund at north of 5%.

And maybe I’ll just talk about that for a minute. That’s a very interesting business that has been in the UK market for a long time, viewed as quoted private equity. But in actual fact it has really been run as an investment trust, and an investment trust that thinks in the long term about investing in growth businesses. And when we analyse 3i, for us, it’s very much a proxy to some extent for a mid-cap holding because it’s probably got about 12 growth mid-cap sized businesses in its portfolio, all of which we think are structurally growing.

It has one very important asset called Action, which is a discount retail format in Europe that we think is a very exciting business. It has about 2,000 stores across Europe today. It has the opportunity set it believes to grow to about 6,000 over the next 5, 6, 7 years. And so, when we look at 3i, we’re not thinking about it as a financial, we’re looking at the underlying operating assets and we view them as very attractive value, given you’re buying the shares today at around its NAV. And historically, it’s compounded at about 20% a year that NAV, with a 3.5% dividend yield, which we think is really very attractive.

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